Berkonomics – Business Insights from Dave Berkus

          Once a company founder has tapped the funds available from his or her resources and from friends and family, if the company needs more cash for growth, the most obvious next step is to look for money from angel investors and venture capitalists, typically in the $300,000 TO $3,000,000 range.  This money comes with restrictions a founder may not expect, including restrictions upon the sale of founder stock, clauses that require the investor be allowed to sell an equal proportion of stock upon any other person’s sale of stock, anti-dilution provisions that protect the investor from a subsequent offer of stock at a lower price, and much more. 

          Almost always, professional investors, including angel groups and venture capitalists, also require at least one seat on the corporate board.  The investor organization is granted the seat as long as the investment remains, and the documents often name the first representative assigned by the investor group to the position.

[Email readers continue here...] In subsequent insights, we will explore the legal and ethical responsibilities of board members.  But the intent of these “forced” placements of a representative on the board is obviously to watch over the company’s use of invested funds and to help grow the company in value.  The combination of restrictive covenants in the investor documents and the new dynamic of board members with an agenda make for a change in the culture of the corporation, certainly one for the CEO.

           However, outside professional investor board members can be a very good asset to the corporation with the skills, experience and broad relationships many bring to the boardroom table.

Equity is the currency of early stage businesses.

                 The truth of this statement may be obvious, but the execution of a good incentive program using equity is often mismanaged, damaging the corporate capitalization structure and even affecting the outcome of subsequent investment into the company.

                First, a brand new enterprise is often formed from the efforts of several “partners”, each with an expertise valued by the others.  Equity is divided between the founders and the business begun.  Although this insight does not address this point of ignition, we should note in passing that things always change over time, and formerly strong founder-contributors can become a drag upon a business or loose interest if the enterprise is not quickly successful.  To protect against this, there must be some document in place from the beginning that clearly states the expectation of each founder as to contribution of time and resources to the enterprise.  The document should also contain clear buy-sell clauses, forcing any sale of shares to first be offered to the corporate treasury, then to the other founders in proportion to their holdings, and then if no interest, to outside investors.  It should contain a mandatory sale clause in the event of separation of a founder, so that a major owner who is passive in the enterprise cannot easily vote against measures other active founders endorse. 

                The real insight here is that stock options or phantom stock are the tools of early stage businesses used to attract great talent when there is not enough cash to pay market rates.  There are some rules.  First you must create a stock option plan using your attorney, which must be registered in many states as a security offering. (The fee for registration is well under $100, so this is not an issue.)  Options are usually best with “C” corporations, but granting options for either LLC’s or “S” corporations are not a real problem. 

                Most early stage companies make the mistake of making option grants to new hires at all levels that are too aggressive and distort the capital structure of the company to a degree that damages future professional investment.  Let me try to advance a few rules of thumb to help guide you here.  [Email readers continue here...] An option plan should carve out an addition of about 15% of the “fully diluted” shares.  If there are 85,000 shares issued to the founders, then a plan calling for 15,000 shares in a pool reserved for future hires is appropriate, making the fully diluted shares 100,000.  The board must approve the plan including this number, and shareholders must approve the plan as well.  Each grant to new or existing employees must be approved by the board before issue.

                The price per share for option grants is also an important consideration.  IRS rule 409a specifically calls for an appraisal of the value of the corporation’s stock current to within a year of any grants of options, although there is an exclusion for early stage businesses in which expert members of the organization or board may make such an appraisal if they qualify according to the exemption.  It there is only one class of stock, the same as the founders, and the appraisal of the single class of shares yields, say $2.00 a share, then options must be priced at that amount.  In other words, you cannot create bargain options at below “market rates.”  If you have a preferred class of stock with special protections, that class of shares will be valued at a price higher than the founder common shares, allowing stock options to carry a lower price per share than preferred investors may have paid.  This is important because high quality candidates should be induced to consider coming aboard at lower than market salaries using the tool of “cheap” options, properly priced.

                What percentage of the total company shares should be reserved for what specific job titles?  Inducing a new CEO to come aboard usually means creation of a stock option package of 5-8%. That size of grant would take much or most of the option pool.  A vice president, or CxO candidate, typically is offered between 1% and 1.5%.  Director level employees are typically granted ½%.  All other grants usually are much lower, allowing for the typical 15% pool to last for quite awhile in most companies.

                We will cover board members and advisory board members at a later time. 

                Options typically are earned over time, which we call vesting.  If a grant of 10,000 shares is made on January First, typically there is a four year vesting period in which the employee earns the right to exercise (buy) 1/48^th of the shares each month.  Many plans also call for a one year “cliff” in which an employee who is separated from the company before a year is unable to exercise even the shares which would have been vested at that point.

                There is an important consideration that will become an issue with sophisticated candidates for VP and above.  We call these “trigger” provisions, in which selected options negotiated for a select group of senior managers, fully vest to 100% upon any change of control.  This provision allows these select individuals to perhaps profit handsomely in an acquisition by being able to exercise their options in full at the time of sale.  The negative side of this is that the buyer may not want to so enrich these managers that they may not be willing to come aboard the buyer’s organization, even if the existing options are replaced with options from the buyer company.

                If all of this seems a bit overwhelming, we have just scratched the surface of option plans and incentive compensation.  This is an area of expertise that a CEO is required to quickly learn and carefully manage with the help of the corporate attorney and the board.

                  You can take “everything changes” as a rule, not an exception.  You’ll recognize the truism, “No battle plan ever survives contact with the enemy” first stated by German Field Marshall von Moltke in the 19^th century.  This variant of the “battle plan” truism is important to internalize.  A product at the concept stage contains feature-functionality that customers may not want or be willing to pay for, or which just might not work well enough for release to the public. 

                You may recall that Microsoft planned a new file system for Vista, but pulled the file system from the product before release, and has not released the WinFS file system yet as of this writing, years later.  It is interesting to note that not many of us even remember this “feature” let alone miss it.

[Email readers continue here...]  Plan for change; sometimes at the last minute.  Allow for the cost and extra time for tweaks to the product or service.  Make the first release a limited, controlled one, so that changes and corrections can be made much more easily than if a general release all at once. 

                And how do we protect ourselves against surprises that relate to feature-functionality as opposed to product quality upon release?  Early contact exposing friendly close customers to the product are critical to the development staff, marketing and even to the customer that feels closer to your enterprise as a result of the special treatment.  This is not to state that the customer tests a new product before we do internally, although many of us are surely guilty of that error. 

                 Back when I was developing early systems for the hotel industry, with the full cooperation of the owner and managers of a hotel in Tulsa, Oklahoma, I would fly in from Los Angeles on Friday evenings, install new releases that night and make fixes on the fly in a real 24 hour environment.  Sunday afternoon, just about departure time for my scheduled flight, the hotel manager would drive me to the airport barely in time to make the returning flight.  My excitement in having developed so many new and “somewhat tested” features over a sleepless weekend was exceeded only by the enthusiasm of the entire hotel staff for the new and wonderful capabilities left behind after the magic weekend of non-stop programming.  

                  These trips were so common and their aftermath so predictable (a late night emergency repair call waiting for me at home upon return Sunday evening) that the hotel owner created a mantra that stuck with me and caused quite a laugh at my expense for years.  He would be sure to remind his staff, shaking my hand goodbye as I left in a hurry to catch that Sunday evening flight: “Wheels up, system down.”  I am not advocating such brazen behavior today.  “Cowboy coding” is no longer common or permissible in the computer software industry, especially for enterprise systems.  But those were the days.

This insight follows closely the conclusions from the previous declaration, that professional investors negotiate tough terms, from provisions of control over asset acquisition, eventual sale of the company, future investments, forced co-sale when others attempt to sell their shares and more.  And yet, in an earlier insight, we spoke of the problems that come when taking unstructured investments from friends and family.  So how does the statement above fit into this sandwich of alternatives?

                Trusted, close resources include sophisticated relatives, friends and business associates who know how to structure a deal as a win-win for you and for them, while allowing you to retain control over your vision and execution.  Their investment should be structured with the help of a good attorney who understands the mutual goal of maximum leverage of funds with minimum interference in your business decisions. 

                Remember the admonition that investment from such close sources carries an additional burden for you – to protect your investors and their investment as if they were your alter egos, offering money as if from your own pocket.  Such money should never be taken without clear understanding of the terms, whether a loan with a reasonable interest rate and strict repayment terms, or an investment valuing the company at an amount considered reasonable by a third party professional, even if as a sanity check as opposed to an appraisal.  This money is personal, an investment in you as much or more than in your company.  The degree of care you take increases with the reduced distance between you and your investor. 

                [Email readers continue here...] My very first investment as a professional angel was in a small startup where the entrepreneur’s vision fueled my imagination in the audio market niche where I had run a business in an earlier life.  I was so enthusiastic that I coached the entrepreneur to approach his mother, who invested $50,000 under the same terms as my investment.   A small venture firm and a few more angels rounded out the total investment.  As the company grew and became profitable, it became more visible to others in the market niche.  Two of us who invested served on the board of the company, advising the first-time entrepreneur with our business and industry experience.  Several years later, with the approval of the board and entrepreneur, I was able to engage a very well-known potential acquirer of the business who offered an attractive price for the still-young but successful enterprise.  After weeks of negotiation, the entrepreneur suddenly disengaged, claiming that he was no longer interested in a sale of his company.  The rest of us were shocked and disappointed that after weeks of work and a fair price, we were left with nothing but to follow his lead and disengage.  Shortly thereafter, in a board meeting, I brought up the issue of starting to pay board members for service in cash or in stock options, typical for outside board members but rarely for investors.  The entrepreneur was angry, abusive, in his negative reaction to even bringing the issue to the board for a discussion.  Five years had passed from my original investment in what I now clearly perceived as investment into a lifestyle business, one where the entrepreneur had no interest in selling or sharing.  I resigned from the board on the spot and negotiated a sale of my stock to the entrepreneur at five times the earlier investment, a fair return for both, since the company was by then worth much more.  It is now years later, and his mother along with other early investors are still in the passive game, not likely to see liquidity from this mistaken investment in an entrepreneur unwilling to take money in exchange for the eventual promise of liquidity.

                Why tell this story at all?  Mother is surely satisfied as a passive investor who probably would have given her son the money without structure.  The other investors are probably in the unhappy never land of not being able to see liquidity after a decade and unable to write off the investment as a loss for tax purposes.   This story would probably have ended in a lawsuit if a larger professional investor had been involved, since the entrepreneur did not follow the rules and seems to have no desire to do so.

                Trust works both ways.  Take money from close resources, but treat it as if the responsibility is even greater to protect the investors and their money than from a professional.   These investors trust that you will do the right thing for them if at all able.

               Let’s spend a few moments defining a sometimes confusing set of terms.  A budget should be created each year as a result of a series of negotiations between departmental managers and their superiors through to the CEO, all in support of the next year’s tactics previously agreed upon (which in turn support the longer term strategies leading to the next goal beyond).  

                So a budget sets the limits upon spending for the next year that are negotiated between the players.  An important part of the budget is the expected revenue for the coming year, a critical factor in setting hiring and resource expectations for the year.  During the year, if the forecast revenues fall short or are greatly exceeded, it is fair to revise the budget and rethink hiring and resources.  Otherwise, it is the expectation of the board of directors of a company that each year’s budget be approved in advance and adhered to as long as revenue goals are met.

               [Email readers continue here...]   Note that I used the term “forecast” for revenues for the next year.  The term is also used when projecting revenues for succeeding years. The term “forecast” is a bit confusing, because it is also used by some as a measure of expected revenue and expenses to the end of the current year, found by taking actual performance year-to-date and adding best estimates of remaining revenues and expenses for the rest of the year to obtain an expected or “forecast” outcome at yearend.  Both uses of the term are common.  Just be sure all who participate understand which use of the word is the current one.

                The real point here is to create a financial plan to support the strategic plan, marrying them in harmony one with another.  Many entrepreneurs are impatient by nature, not the best of detailed planners.  Yet, with the assistance of those in support such as the CFO, everyone in management must be aligned in a single direction, reviewed and updated annually as accomplishments, the marketplace, and even the competitive landscape change.

I have a business friend, an experienced manager and teacher with a Harvard MBA, whose creativity and intelligence are admired by many. But he dilutes his effectiveness with wordy PowerPoint presentations. It has become a long running joke between us, as I often remind him that most of us have a very limited attention span and ability to recall important points from a presentation.

Note the title and tone of these insights. Short, to the point.

Mark Twain said, “I didn’t have time to write a short letter so I wrote a long one instead.” He cogently encapsulated the problem.

It is more difficult to reduce your thoughts to a few core sentences, but that is what you should do for maximum effect.

Companies that innovate new products, services and methods of delivery are the ones that stand out in a crowded business world, especially when attempting to gain recognition beside competitors on the web. 

Innovation is valued by our society, by investors and certainly by consumers.  It is the focus for state and federal governments worldwide, many finding ways to reward innovators with tax incentives or investors with tax credits to finance innovative new enterprises.

As a keynote speaker, I often start presentations with a short history of innovation in the United States, using the twist of examining innovation through the lens of 150 years of cyclic bursts of bubbles, leading to subsequent recessions and depressions.  It is not hard to find strands of gold in the carnage left by failed businesses lost when a bubble bursts, such as in 1857, 1902, 1929 and 2001.

Innovators make use of golden strands of opportunity left when the unfinished vision of another cries for completion, or when a genuine new concept changes the very way people think about their lives.

[Email readers continue here...] Leonard Kleinrock and a few of his UCLA computer lab students worked to send the first several characters from UCLA to Stanford in 1969 over a direct line established for the test.  They were able to send only the “LO” of “LOGON” before recording the very first crash of the Internet.  And I’m sure they had no idea what they were fathering with that effort which eventually became ARPANET, and then of course, the Internet itself.  They had no mantra, and a limited vision to connect mainframe computers to share academic information.

How many entrepreneurs used that infrastructure to create an expansive vision of what could be?  Tim Burners-Lee wanted to use this new infrastructure to create a friendlier web of pages, sharing data like the pages of a massive library of books extending throughout the world.  The result was the worldwide web, upon which Mark Andreeson and his crew in Chicago build the Mosiac browser to make this data more available to anyone.  Which in turn allowed innovators worldwide to create applications inside a browser, share detailed information previously locked inside libraries and corporations, and ultimately to change the world by making the exchange of information frictionless.

We can look back to Edison, Ford and Bell as great innovators of their time.  But perhaps the most impressive invention of recent times is the result of hundreds of people, firms, and institutions, each adding a new brick to the building of the Internet.

Now we have the infrastructure for innovators to create applications with free software on computers used for many purposes simultaneously.  And millions of innovators are at work extending the capabilities of the Internet.

What opportunities are next?  Perhaps it is the remaking of the world through green technologies, clean technologies, new medical technologies, new home entertainment products, new mobile communications products and services, and more.

Who said that “Everything that can be invented has been invented?”  Ah yes. That was Charles H. Duell, U.S. Commissioner of Patents in 1899.   Oops.

A vision must be solid and flexible enough to pass a number of critical tests if it is to guide a business enterprise to greatness.  Here in brief are ten tests for a successful vision.  Try these on for size, and test yourself for attractiveness to the marketplace, to investors and to history.

Ten tests for a successful vision

1.  Is your market identifiable and accessible?    Test yourself as to whether you can identify the size of your market niche, and whether you can overcome the many barriers to access customers within your niche.

2. Where in industry life cycle?     If your vision is for a product or service that fills a need in a mature industry, you may be flying against the prevailing winds as a market shrinks over time, taking your business with it.  Conversely, a fast growing industry lifts most all good participants, making excellent companies excel even more and grow even faster, like a small plane flying at 150 knots with a 75 knot tailwind.

3. How large a total market?    If the total market for your niche is under $100 million per year, it is going to be difficult to build a $50 million business, even if not impossible.  If the market is ten times that size, there is probably room for competitors to fight for dominance and still succeed if you are not number one.

4. Can you dominate that market?    The dominant player in any niche controls pricing for all those under it, and often sets the risk profile for new entrants into the niche if the dominant player’s products or services fill the needs of customers at reasonable prices and quality.

5. Have you created high barriers to entry?    If your business is a “me too” entrant into any market niche, even the smallest success will soon attract competitors that will sap some degree of your potential growth. What can you prove as a barrier to entry for competitors?  Is it the advantage of time – years of development ahead of any competitor? A core patent or “thicket” of patents protecting your offering?  A strategic relationship with one or more of the largest customers?

6. Are margins high enough?     Some great ideas just can’t make money and ultimately die for lack of profit potential.  Profit margins are higher for unique products or services early in the life of an industry niche, or for products protected by patents that prevent others from undercutting you simply by releasing a cheaper product.  High profit margins are a sign of high barriers to entry and attract investors and ultimately good buyers for your business.

7. Can this business grow to above $20-50MM?     This is a basic test for investors, separating your business from those with smaller visions.  There is nothing wrong with a vision for a smaller enterprise if not in need of professional investors to make it a reality.

8. Do you have a world-class management team?     The best way to protect against failure is to attract a team with members who have experienced success and failure and can recognize the ways to manage toward success and avoid the pitfalls previously experienced from past failures.  From a professional investor’s perspective, the team should be able to be flexible, coachable and experienced enough to get a business through breakeven and beyond the next level of outside investment, greatly reducing execution risk.

9. Can you translate an idea into a compelling product?    Some great ideas just cannot be made into a product at a reasonable enough prices to attract customers.  And some attract early adopters but cannot pass into the mass market.  Sometimes, an idea is just too early for the available technology to make it attractive.  Early cell phones were large bricks that required a large carrying case and cost up to a dollar a minute to use.  As technology caught up, allowing miniaturization and light weight, mass adoption drove the price down and allowed the building of infrastructures everywhere to support the use of inexpensive minutes.  Do anything you can to develop compelling products or early prototypes as proof of ability to reduce technology risk.

10. Is there an exit strategy for the investor(s) over time?     There are many professional services businesses that make fine lifestyle opportunities for architects, doctors and dentists.   But these types of businesses are not attractive to potential buyers willing to pay a premium for businesses that are worth millions more than their asset value.  Building a great business to create wealth for the entrepreneur at exit, means thinking of the exit strategies from the beginning.  Who or what type of buyer would be attracted to this business if successful?   Great wealth is made from selling great businesses at immense profit for the entrepreneurs and investors who took the journey.

Depending upon your stage of development, if you are at the initial creation stage of your business, you might now revisit the earlier posting, “The Berkus Method” (under “Raising Money” in the contents index for this blog) for determining early stage enterprise value for investors.  However, these ten tests certainly apply to all stages of a business’ development as entrepreneurs then professional management work to ctreate extraordinary value for the enterprise.

I love absolute statements. And this is one of my favorites.  You’re at the ignition stage of a new business venture.  Of course you have a vision for what that business will do to change the world.  And this insight is directed to you in an attempt to stress test that vision and sharpen it further to help insure your success.

Let me address those whose vision may be limited and who will be happy with a successful local dry cleaning enterprise or small restaurant around the corner.  Although many of these insights will help you succeed, you are not the target for this epic effort to help entrepreneurs build great businesses that do change the world.  Take what you can from these bursts of insight.  I wish you well in your endeavors.

For the rest of you who want to change the world, I am with you and happy to offer all the help I can to reinforce your opportunities for success.

To you, let me repeat: vision is everything.  A great vision for a new enterprise drives innovation. It serves as the rallying cry for all future employees, investors, customers and even suppliers.  It sharpens the understanding of those new to the enterprise and moves them to follow and even to become unpaid advocates for the business. 

[Email readers continue here...]  Think of some of the great visions from the past that did change the world.  “Absolutely, positively overnight” made FedEx an indispensible name in supply chain management.  “A computer on every desk” made Microsoft a partner in the growth of most every business.   You can think of many more, visions expressed so clearly that the enterprise became critical to your own success.

There are other, less dramatic ways to express a vision.  “Be the largest supplier of laser toner in North America”, or “Make dining into a five star experience.” 

Years ago, as a panelist at an entrepreneurial seminar, I watched as over fifty aspiring young entrepreneurs filed past a microphone, each tasked with making a thirty second pitch to the panelists of professional investors.  About halfway through this painful exercise, one man walked up to the microphone and said, simply, “We move oil through the Internet” and then he moved on.  Immediately after the panel presentation, I found that one entrepreneur and began a conversation that led to my investing $100,000 in his vision of a supply chain enterprise based upon perfect knowledge of oil delivery systems, precise timing of delivery and coordination of resources to move oil from source to customer using the Internet as a frictionless tool for communication and coordination. 

Although that business ultimately failed, I still speak with that entrepreneur as he uses his experience in a new field, better off as a result of his learning experience.  I carry no rancor as a result of the loss, since I bought into the vision, helped as I could with the execution, and came to the realization along with the entrepreneurial team that the number of uncontrollable elements far exceeded those which could be controlled by any third party at that stage of development of the Internet.

We will explore vision in more depth in recognition of its importance to success.

Don’t take from others and don’t let others take yours.

                We must pause in this journey toward building an overwhelmingly successful business with an admonition that may seem obvious to some and completely sail over the heads of others.  Most entrepreneurs arrive at the starting line of a new business with a vision for the future and some degree of experience from the past.  Often, that experience comes from being employed within a business that was similar, but whose senior management may have missed or deliberately ignored what the entrepreneur sees as a great opportunity.

                And most senior and middle level managers will understand when a subordinate comes to them to resign and begin a new business.  But all will immediately question whether the new business will compete in any way with their enterprise, and react to the future entrepreneur in either of two very distinct ways based upon those fears.

[Email readers continue here...]      If the employee who is about to resign is off to conquer the world in a completely new arena, there is almost always the unspoken sigh of relief and a cooperative attitude that flows from the senior manager  from that point on in the conversation.

                But if the employee is even a little bit reticent to tell of the plan envisioned,  the result is the first stage of what could become an outright war between the present employer and a newly separated past employee, sent away that day with an escort out the door. 

                The same attitudes from past employers can be expected if a past employee resurfaces after a layoff, resignation or after being fired, with a plan for a competitive business.  Most employers have all their employees sign non-disclosure and confidentiality agreements to protect the company’s trade secrets, customer lists and business plans.  Many states recognize the right of a former employee to work, even if in direct competition with a past employer.  But that right clearly stops when the entrepreneur uses any trade secret data from the past employer, especially customer lists for contacts and confidential business plans as bases for new businesses. 

                Anyone can be sued even if without merit, and responding to a suit can be traumatic in many ways – from expenditure of cash and valuable time to emotional drain from worry over a negative outcome, to loss of industry goodwill by an entrepreneur perceived to have stepped over the line.

                This is especially true for someone who has sold a business only to surface later to compete in some way with the buyer.  Never underestimate the venomous response from such a threat.  

                So no matter what your circumstance, never, ever be guilty of using trade secret materials or ideas from your past employer, especially customer lists.